2.11 Bond Characteristics

The yield of a bond is a function of two variables, and may be written as follows:

YTM = ƒ (Creditability, Maturity)

Two bonds may have the same credit rating and maturity, different coupons, but the same YTM (market yield), and hence different dollar prices/values. In the example above, the positive- and zero-coupon bonds had the same YTM, but different dollar prices.

Creditability = ƒ (default risk)

The credit rating agencies evaluate default risk and come up with ratings; this is NOT a perfect system and such ratings are not always accurate.

A bond’s maturity will also influence its yield, for a given default risk, as determined by the slope of the “yield curve.”

Slope of the (“Normal”) Yield Curve = ƒ (Liquidity Preference)

The investor’s optimal state is “cash”; with cash, the investor’s options are completely open – he can spend or invest as he chooses. “Liquidity Preference” is the notion that investors demand greater return (i.e., YTM) for longer term maturities since a greater term-to-maturity requires tying up one’s money longer and thus increasingly foregoing liquidity, i.e., being “in cash.” As one increasingly ties up his funds, he demands increasing returns. For this reason, the “normal” slope of the yield curve is positive; there are also other factors which may affect the normal slope.